E1600 Class 2 Notes Alchian & Demsetz, Stigler copy PDF

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Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

Class 2 Notes: Alchian and Demsetz on Production, Information Costs, and Economic Organization Recall from the previous class that organization begins with people specializing; first functionally and occupationally, later by organizing cooperatively around elements of work (e.g. pin making steps) and adopting more complex production functions. Trade emerges to coordinate specialists and leads to a price system or market. Transactions can be performed through the market, e.g. the putting out system, or through hierarchy within firms. There are costs to using the market or price system. Coase argued that firms emerge when hierarchy is more efficient than market transactions. In Coase’s model firm scale and scope limits on firms are determined by diminishing returns to management, the costs of organizing, the incidence of mistakes, and the nature of the markets for factors of production. Objectives: To build on Coase’s notion of the firm through Alchian and Demsetz’ perspective and to take a closer look at the incentives to form firms. We will set the stage for discussing incentives by defining types of firms in light of the intensity of managers’ stakes in their firm’s results. We will touch, all too briefly, on Demsetz’ extension of the ideas contained in the earlier article he co-authored with Alchian. Then we’ll move on to examine George Stigler’s extension of Adam Smith’s theorem about the division of labor depending upon the size of the market to explain the division of labor within and across firms in terms of the shapes of production functions and their relationship to the size of the market. This provides a basis to explore the relationship(s) between the degree of sustainable vertical integration, the practice of outsourcing, and the emergence of new firms in decreasing cost industries. We will extend these principles to explain in part the emergence of clusters.

Increased efficiency Greater potential rewards

Cooperative, team-based production

Monitoring and metering Familiarity with workers Incentive system design Contract design

Difficult to determine individual output Asymmetric information Agency costs Potential for shirking

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Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

Alchian and Demsetz and the Importance of Cooperation as an Explanation of Firms Adam Smith emphasized the productivity enhancing power of specialization and the importance of exchange or trade to realizing its benefits. Dennis Robertson had observed that we find “islands of conscious power in the ocean of unconscious cooperation like lumps of butter coagulating in a pail of buttermilk.” Coase attributed the emergence and dominance of the firm to lower transactions costs within firms due the application of authority and hierarchy. In fact, the great majority of transactions in a market economy occur within firms rather than across firms or individual producers using the price system. Coase pulled economists away from the “black box” or production function conception of the firm and prompted them, eventually, to think more deeply about what firms were and how they functioned. In 1972, Armen Alchian and Harold Demsetz published a very important paper, “Production, Information Costs and Economic Organization,” that extended both our understanding of how firms emerge and connected that understanding to how firms manage their internal transactions and relationships.1 Alchian and Demsetz expanded upon Coase’s narrow transactions cost explanation and focused on the firm’s role in managing cooperative teams in light of information costs and the consequent need for a central contracting authority. “…Resource owners increase productivity through cooperative specialization and this leads to the demand for economic organizations which facilitate cooperation…”2 Where Coase implicitly assumed that market or firm production differed only with respect to transactions costs, Alchian and Demsetz noted that firms made a different sort of production possible. Cooperative, team-based production could be much more efficient than separable, additive market-based production. The firm still has transactions costs, especially for gathering and using information, but the key ones are directed to monitoring and measuring the performance of cooperating resources. On that foundation Alchian and Demsetz developed a systematic picture of the firm’s internal workings; how the role of managers emerged from the need to meter teams, how managers’ incentives to be productive are driven by sharing the residual created by the teams under their direction, and how the intensity of the connection between residual sharing and managerial effort helps to define types of firms. Like Smith, Coase, and Stigler before them, Alchian and Demsetz recognized the importance of specialization in increasing wealth but they defined the problems facing a theory of economic organization a little differently. In their view the theory had two charges: 1

Armen Alchian, Harold Demsetz, “Production, Information Costs, and Economic Organization,” American Economic Review, 1972, Vol. 66, pp 777-95 2 Ibid, page 777 32 Ibid, page 777 4 Alchian and Demsetz, op cit, p778 5 See Nicholas Kaldor, “The Equilibrium of the Firm,” The Economic Journal, March 1934, pp. 60-76. Kaldor distinguished between the “supervisory” and “co-ordination” management roles. He argued that it

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Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

… to explain the conditions that determine whether the gains from specialization and cooperative behavior can better be obtained within an organization like the firm, or across markets, and to explain the structure of the organization.3 Alchian and Demsetz offer a bit of a riposte to Coase’s emphasis on the relative power of hierarchy over markets by arguing that the firm really has no more authority or capacity to discipline resources than does the market. The firm does not own all of its inputs and has access to no disciplinary action more powerful than that between contracting parties in the market. Where Coase suggested that firms arose to perform those transactions that, due to the costs of using the market, could be conducted more efficiently within a firm; Alchian and Demsetz asserted that the fundamental rationale for firms was their superior capacity to foster cooperation among specialists. In their model the firm is the “centralized contractual agent in a team productive process.” 4

I. The Metering Problem Economic efficiency requires paying resources on the basis of their productivity (e.g. payments equal to value marginal product). This is relatively easy in competitive market transactions because the supply of the last unit will be priced at its marginal cost. This condition is harder to achieve within firms, especially when joint, team, or cooperative production methods are used and thus requires internal metering and information. The degree of productivity is directly related to the efficacy of metering. The roots of what Nicholas Kaldor (1908-1986) called “supervisory” management and the identification of its contribution are in the metering problem.5

II. Team Production Alchian and Demsetz identified the jointness of team or cooperative work that was inherently suited to being performed within a firm as the critical characteristic of a firm. 3

Ibid, page 777 Alchian and Demsetz, op cit, p778 5 See Nicholas Kaldor, “The Equilibrium of the Firm,” The Economic Journal, March 1934, pp. 60-76. Kaldor distinguished between the “supervisory” and “co-ordination” management roles. He argued that it was the latter which was fixed for the individual firm and hence the basis for ultimately diminishing returns to other resources. Kaldor built on Austin Robinson’s The Structure of Competitive Industry, and, like Coase, rejected Frank H. Knight’s notion of control resting with those who bear the ultimate risks (perhaps uncertainty would be the more accurate term here). Kaldor defined and explained the firm in terms that seem to anticipate the central contracting agent of Alchian and Demsetz and their emphasis on the residual value as a basis of management compensation, “…for theoretical purposes the most satisfactory definition of a firm is that of a ‘productive combination possessing a given unit of co-ordinating ability” which marks it off from ‘productive combinations’ (such as an industry) not possessing this distinguishing peculiarity. It is the one factor which in the long run is ‘rigidly attached to the firm’ which, so to speak, lives and dies with it; whose remuneration, therefore is always price-determined.” When he wrote this article, Kaldor was still in his neoclassical phase and had not moved on to his later emphasis on macroeconomic issues and the development of Keynesian models. Kaldor was very dismissive of monetarism and is famous for criticizing Milton Friedman’s analogy of increasing the money supply by dropping money from a helicopter (a theme later picked up by Ben Bernanke) and went so far as to discuss the different consequences should the helicopters release their manna over poor or rich parts of London. 4

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Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

In other words, the firm with its central contractor makes possible a more efficient type of production, a type that would be very difficult, if not impossible, to achieve working through the price system or market. Their notion of the firm as a vehicle for promoting cooperation through centralized contracting is significantly different than the classical view of the firm as a set of production functions but is perhaps not really so far from Coase’s notion of firms serving to economize on transactions costs. Today, transactions costs are often defined broadly to include information, search, contracting, and other similar costs associated with exchanges but not directly embodied in the product or service being exchanged. Contracting (explicit or implicit) is the primary means of organizing sustained cooperative effort among people, either inside of outside of a firm. Take a moment and think about the “contract” as a device for cooperation and its relationship to property and property rights. There can be no free or voluntary contracting between people without property rights. Exercising our property rights to our own labor or other resources usually involves transactions costs. The person or firm contracting for our services also incurs transactions costs. These notions are central to the notion advanced by Jensen and Meckling that a firm is a “nexus of contracts.”6 The concepts of a team and team-based production are central to the Alchian and Demsetz model. Teams are a form of cooperative effort that may yield substantial economic gains but involve significant contracting and monitoring efforts. The value of contributions from individual resources in team-based production functions cannot be measured readily because the activity involves joint efforts of team members. Such joint effort may involve the simultaneous effort by team members (e.g.. cooperatively lifting a heavy box) or the use of a shared resource (e.g. shared access to a power supply or an assembly line) by team members. A team-based activity as a whole may be separated from others conducted by the firm in the same way as those discussed by Stigler (whose explanation of firm specialization and integration are discussed below).7 Jointness is a frequently encountered phenomenon in economics. Most students (at least those who took the prerequisite) are familiar with the problem of pricing joint outputs such as beef and hides that result from raising cattle. You may recall that despite the most ingenious, if logically strained, efforts of accountants to allocate joint inputs and their costs to the two outputs: it is impossible to determine separable production or cost functions for the two outputs: one cow, one carcass, and one hide. 6

Jensen, Michael C and William Meckling, 1976, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics, October, 1976, V. 3, No. 4, pp. 305-360. 7 The concepts of production functions and production cost functions are essential to understanding how business firms allocate their resources and make choices about how to produce output given different technologies and factor prices. An accessible review of the production and cost functions by S.K. Mishra, “A Brief History of Production Functions” Working Paper for the Social Science Research Network is available free at http://www.scribd.com/doc/417083/A-Brief-History-of-ProductionFunctions#fullscreen:on

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Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

Jointness arises also with inputs in production functions involving cooperative labor and resources. As Frank Knight observed, “In reality, of course, production is joint, almost without exception.”8 To illustrate joint production Alchian and Demsetz use the example of two men carrying a heavy box that neither alone could lift. We can measure how much the team lifts, but we really can’t say easily how much each team member lifts. This problem of non-separability of joint inputs has bedeviled economists for over a century but as Knight stated, “… it is inappropriate for economists to argue as to whether the separation of contributions to a joint product can or cannot be made; it is made; it is our business to explain the mechanism by which it is accomplished.”9 Alchian and Demsetz offer a solution to Knight’s problem. The team-based box-carrying production function is a very different function than the separable one-man box-carrying models with which it competes. One-man models would, for example, likely require a redesign of the box packaging to make it smaller and lighter or involve breaking the contents into smaller quantities, increasing packaging costs, tracking costs, assembly costs, etc. The two-man box carrying production function will be chosen when its increase in efficiency over the one-man methods is sufficient to compensate the common resource and metering costs. In this simple case common or shared resource is the management activity that can direct the cooperative behavior. In other words there are three resources involved: two labor resources, and one management resource. The latter is justified by its contribution to the efficiency of the former two.10,11 The shared application of physical capital is probably the most important example of cooperative or joint output. When once relatively independently operating textile workers came together to work within mills and to share power sources, it quickly became evident that they could be managed more efficiently as a firm, i.e. through a central contracting agent. More efficient investments in capital assets were possible when a central contracting entity could plan for the full resource base and optimize inputs. This led to changes in the size and capacity of equipment and increased specialization among the workers. In almost all cases, the central contracting entity was the owner of the capital assets used jointly by the workers and other resources. Team or cooperative production is characterized by three factors: 1. Several types of resources are used

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Frank H. Knight, 1921, Risk Uncertainty and Profit, originally published by University of Chicago Press, quotes here are from the Kindle edition by Cosimo Classics, 2005 location 1175 of 4511. 9 Ibid, location 1270 of 4511 10 The workers do not have to be employees to work cooperatively or share a resource. For example, some independent cab drivers jointly operate or support a central dispatcher to provide efficient routing. 11 A team production function e.g. z = f (x,y) is described mathematically by the second cross partial derivatives of the function with respect to the variables: ∂f2/∂x∂y ≠ 0. For example If the production function is z = f(x,y) = x3 + x2y3 -2y2 then fx = 3x2 + 2xy3, and fxfy =∂/∂y (3x2 + 2xy3) = 6xy2. But, if the production function is z = f(x,y) = x3 – 2y2 Then fx = 3x2 and fxfy = ∂/∂y (3x2) = 0. In general at least one term of the production function’s has to contain a product of the variables – an indication of “jointness” and hence a team function.

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Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

2. The product is not the sum of separable outputs of each resource12 3. Not all of the resources belong to one person Jensen and Meckling point out that the Alchian and Demsetz over-emphasize the role of technical jointness and that their argument holds where agency costs and multiple contracts are involved. “Alchian and Demsetz (1972) object to the notion that activities within the firm are governed by authority, and correctly emphasize the role of contracts as a vehicle for voluntary exchange. They emphasize the role of monitoring in situations in which there is joint input or team production. We are sympathetic with the importance they attach to monitoring, but we believe the emphasis that Alchian and Demsetz place on joint input production is too narrow and therefore misleading. Contractual relations are the essence of the firm, not only with employees but with suppliers, customers, creditors, and so on. The problem of agency costs and monitoring exists for all of these contracts, independent of whether there is joint production in their sense; i.e., joint production can explain only a small fraction of the behavior of individuals associated with a firm.” Jensen and Meckling’s insight is a valuable qualification to the original Alchian and Demsetz argument and was largely adopted by Demsetz in his follow-up article discussed below. Technical jointness is not necessary for a divergence between principal and agent objectives and for asymmetric information to emerge. Nothing is lost by thinking of team production in lieu of technically joint production.

The Insidious Temptation to Shirk Alas, team members are human and some are inclined to exploit the difficulty of determining individual contributions in a joint or team production setting. The incentive to shirk (shirking is a form of moral hazard and similar to the free rider problem) is inversely related to the costs of detection and directly related to the value that the shirker places on his relief from effort. Recall that we emphasized that people seek to maximize their self-interest as reflected in their utility function. People will shirk and gain leisure when the value they place on it is less than the costs they expect to pay. Economists note that each team member possesses asymmetric information; each knows how much he is shirking but it is difficult for others to be sure.13 The shirker gains all of the benefit arising from his indolence but pays only a share of the lost value. Team 12 Michael C. Jensen and William H. Meckling, Journal of Financial Economics, October, 1976, V. 3, No. 4, pp. 305-360. Reprinted in Michael C. Jensen, A Theory of the Firm: Governance, Residual Claims and Organizational Forms, Harvard University Press, December 2000 available at http://hupress.harvard.edu/catalog/JENTHF.html Also published in Foundations of Organizational Strategy, Michael C. Jensen, Harvard University Press, 1998. 13 Even in the two-man box carry, one worker may suspect the other is shirking but unless they have worked together for some time, cannot really distinguish shirking from less strength or capability.

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Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

production makes it more difficult to detect shirking. A team member has therefore more incentive to shirk than the same person working in a non-cooperative or independent fashion where shirking is much easier to detect and the entire costs are more likel...